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The Right Way to Inherit

While an inheritance is often considered a gift by the recipient, from a tax perspective, there optimal ways to inherit a retirement account. From the language used to designate the beneficiaries to important IRS-imposed deadlines, the manner in which a retirement account is inherited can significantly affect its value. If you are the beneficiary of an IRA, it is important to understand the requirements and deadlines for withdrawals in order to avoid significant penalties.

Required Minimum Distributions

The primary issue with retirement accounts is that the IRS wants to ensure that assets are withdrawn on a timely basis so that they can collect the income tax due on these tax-deferred assets. Typically, Required Minimum Distributions (“RMD”) from a retirement account must begin by April 1 of the year in which the account owner would have reached age 70 ½ (the Required Beginning Date or “RBD”). If the RMD is not taken by the account owner or beneficiary, then a significant penalty equal to 50% of the amount that should have been withdrawn will be imposed.

RMDs during the account owner’s life are determined by IRS tables based on the owner’s life expectancy. Upon the death of the original account owner (the “decedent”), RMDs are determined based on the decedent’s age at the time of death and his or her relationship to the beneficiary. Due to the various scenarios that may occur, the analysis below is categorized by the relationship between the decedent and beneficiary and whether the decedent dies before or after the RBD.

Spouse as Beneficiary

If the decedent died prior to the RBD, the surviving spouse may choose to treat the account inherited from the decedent as his or her own account. This treatment typically offers a significant tax advantage and is an option that is only available to spouses. On the other hand, the surviving spouse may choose to start taking distributions based on his or her own life expectancy. The third option is for the surviving spouse to withdraw the entire balance of the account by the end of the fifth year following the year of death.

If the decedent died after the RBD, the surviving spouse may again choose to treat the account inherited from the decedent as his or her own account. However, the decedent’s RMD for the year of death must be withdrawn before pursuing this option. The alternative option is to leave the account in the decedent’s name. Again, the decedent’s RMD must be withdrawn by the end of the year of death using the decedent’s life expectancy. The surviving spouse’s life expectancy will be used to calculate future RMDs. While this second option allows the surviving spouse to keep the account as it stands, it is rarely the most beneficial option for income tax purposes.

Non-Spouse Beneficiary

If there are multiple beneficiaries named, the first step should be for each beneficiary to establish his or her own “Inherited IRA” no later than December 31 of the year following the year of the decedent’s death. Assets that are continued to be held in an account with multiple beneficiaries past this date will be required to take RMDs based on the life expectancy of the oldest remaining beneficiary of the account. This treatment will result in younger beneficiaries not being able to maximize their available tax deferral.

If the decedent died prior to the RBD, a non-spouse beneficiary may take distributions based on his or her own life expectancy. The first withdrawal must occur by December 31 of the year following the year of death. On the other hand, the beneficiary may elect to use the five-year rule. If the beneficiary chooses this option, he or she does not have to begin taking RMDs in the year following the year of the original owner’s death. Instead, the beneficiary can withdraw assets from the inherited IRA at any time, in any amount, but must withdraw all assets by December 31 of the fifth anniversary year following the IRA owner’s death. This is often the simplest of options if the requirements were met.

If the decedent died after the RBD, a non-spouse beneficiary must begin taking minimum withdrawals over the beneficiary’s life expectancy. The first withdrawal must occur by December 31 of the year following the year of death. In subsequent years, additional RMDs must be taken by December 31 of each year. Again, as mentioned above, if there are multiple beneficiaries on the same account and such account is not divided and separated by December 31 of the year following the year of the decedent’s death, then the life expectancy of the oldest beneficiary (shortest life expectancy) must be used to calculate the RMDs, which will result in larger RMDs and thus a larger tax liability than necessary for the younger beneficiaries.

Trust as Beneficiary

A trust named as the beneficiary of a retirement account may be a qualifying or non-qualifying trust.

In order for a trust to be a qualifying trust, it must (a) be an irrevocable trust or have become irrevocable upon the death of the decedent, (b) be valid under state law, and (c) name identifiable beneficiaries. While the first two requirements are straightforward, the third can be difficult to decipher. The beneficiaries of a trust that is expected to receive retirement account assets after the owner’s death should be individuals, rather than charitable organizations, estates, or other entities that do not have calculable life expectancies. In addition to the requirements stated above, the trustee must provide a copy of the trust or a list of the trust beneficiaries and their entitlements to the custodian or plan administrator by October 31 of the year after the account owner’s death.

If the trust is a qualifying trust, then the beneficiary may take RMDs based on the life expectancy of the oldest beneficiary of the trust. Unfortunately, even if a trust is to be divided into sub-trusts for each beneficiary after the account owner’s death, the age of the oldest trust beneficiary must still be used. One way to circumvent this requirement would be to either name each beneficiary or each sub-trust individually as the beneficiary of a share of the account. If this is done, each individual beneficiary or sub-trust beneficiary will be permitted to use his or her own life expectancy in determining the RMDs.

When deciding whether to name individual beneficiaries or the account owner’s Revocable Living Trust as the beneficiary of a retirement account, there are several issues that must be considered. As mentioned above, by naming individual beneficiaries, each beneficiary will have the option to take RMD withdrawals over his or her own life expectancy.

On the other hand, naming a trust as beneficiary offers significant protection to the beneficiaries of the trust. The grantor of the trust has the opportunity to delay the ages of distribution of such assets. Without a trust, the beneficiary would be entitled to withdraw all assets at any time after attaining age 18. An additional concern with retirement accounts is that the beneficiary may not understand or appreciate the benefits of a tax-deferred account. In other words, the beneficiary may only see that he or she can withdraw assets immediately, despite any penalties or income tax liability, rather than understanding the value of deferring income taxes.

A properly drafted trust also provides significant asset protection for the beneficiaries by empowering the trustee to delay withdrawals if the beneficiary is going through creditor, divorce or substance-abuse issues. The grantor may also impose employment or parenting requirements in order for a beneficiary to take withdrawals from a trust.

If the trust is a non-qualifying trust, and the decedent died after the RBD, the trust’s RMD will be based on the remaining life expectancy of the decedent. If the decedent died prior to the RBD, the assets must be completely distributed by December 31 of the fifth year following the year of the IRA owner’s death.

Conclusion

Upon a death, a retirement account can be the most significant and complex asset to administer. The IRS-imposed requirements and deadlines can seem like a difficult minefield to navigate through. However, with proper planning and beneficiary designations, the account owner can ensure that his or her loved ones will inherit the assets in the most timely and cost-efficient manner possible.

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Manish C. Bhatia is an Illinois attorney focusing his practice on comprehensive estate planning, including asset protection, probate avoidance, trust and estate administration and planned gifting. Manish values understanding of all estate planning options and decisions so that your documents are an accurate reflection of your wishes. You may contact Manish at manish@mcb-law.com View all posts by Manish Bhatia

About Epilawg

A collection of legal and non-legal insights for living your life and planning for the resolution of your life story. Topics cover business, estates, trusts, tax, real estate, finance and more provided by a variety of professionals in those areas. Learn more >